Does your construction company follow U.S. Generally Accepted Accounting Principles (GAAP)? If so, there’s an important deadline coming up later this year that you should start thinking about right now.
For annual periods beginning after December 15, 2019, and for interim periods beginning a year later, GAAP-compliant companies must begin following the Financial Accounting Standards Board’s (FASB’s) new standard for accounting for leases. (The rules are already in effect for public companies; early adoption is permitted.)
Potential adjustments
Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), classifies leases into finance leases (that transfer control of assets at the end of their term) and operating leases.
Lessees must recognize operating leases on their balance sheets as a right-of-use (ROU) asset and a corresponding lease liability. This is measured initially at present value of lease payments. Also, the cost of the lease is allocated over the lease term, generally on a straight-line basis.
Your accounting for finance leases may call for adjustments. You’ll generally need to recognize a ROU asset and a lease liability, initially measured at the present value of the lease payments, in your balance sheet. You’ll also have to recognize interest on the lease liability separately from amortization of the ROU asset in your income statement.
Last, you must classify repayments of the principal portion of the lease liability within financing activities, and payments of interest within operating activities, in your statement of cash flows.
Lessors’ perspective
If your construction company leases assets to other entities, the ASU does include some “targeted improvements” for lessors’ financial statements. They’re intended to align lessor accounting with both the lessee accounting model and the updated revenue recognition rules. For example, lessors may be required to recognize some lease payments received as deposit liabilities in cases where the collectability of lease payments is uncertain.
In addition, the ASU changes the definition of “initial direct costs” to include only incremental costs that wouldn’t have been incurred if the lease hadn’t been executed, such as commissions or payments to incentivize an existing tenant to terminate. Costs that were previously included but would have been incurred even if the lease hadn’t been obtained — for example, fixed employee salaries — are now excluded.
The new standard also requires lessors to separate nonlease components that transfer a good or service to the customer (for example, common area maintenance or utilities) from the lease components. Lessors will account for only the lease components, according to the ASU.
ASU 2018-11, Leases (Topic 842): Targeted Improvements, allows lessors to choose not to separate nonlease and lease components in certain circumstances. In this scenario, you’ll be able to account for each separate lease component and related nonlease components as a single lease component.
Changes to lease terms
The new rules for leases could affect lease negotiations. For example, variable lease payments, such as rental payments based on the Consumer Price Index or a percentage of retail sales, aren’t included when determining a lessee’s lease asset and liability. For leases with such provisions, the lessor’s initial base rent may be its only reportable fixed payment.
A lessor’s liability for a fixed payment lease generally will be greater than the liability for a variable payment lease. So, expect that some lessors will want to negotiate more variable terms in their lease payment structures for this reason.
In addition, the ASU allows lessees to elect not to recognize assets and liabilities for leases with a term of 12 months or less. Lease terms of 12 months or less will be accounted for similar to existing guidance for operating leases today. This will potentially make shorter terms more desirable — especially for lessors with debt covenants based on liabilities.
Alternatively, these lessors may prefer finance leases because interest and amortization expenses would be excluded from their EBIDA (earnings before interest, depreciation and amortization).
Potential effect
There will also be new disclosure requirements so that users of financial statements can understand more about an entity’s leasing activities. Work closely with your CPA to understand whether and how the ASU will affect you.
We welcome the opportunity to put our construction industry expertise to work for you. To learn more about how our firm can help advance your success, please contact Dave Wolfenden at (302) 254-8240.
